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Emerging Markets Down the Tubes

Updated July 18, 2001 12:01 a.m. ET

By David Roche, president of Independent Strategy, a London-based investment consultancy

This emerging-market crisis is different from its 1997 predecessor. The good news is that it's unlikely to go global. It won't spread to United States, Japanese or European financial markets and economies. The bad news is that it jams the brakes on Asian growth even harder than the region's overdependence on information technology commodity exports. And it darkens prospects for Latin America to a midnight pitch.

There are five reasons why the rich world's financial markets and economies will escape relatively unharmed. First, this crisis catches investors a lot less off-guard, and with much smaller exposure, than the one in 1997. As financial markets increasingly drive economies, this crisis will not drive down global financial markets and endanger recovery in the already fragile U.S. economy.

Second, huge amounts of money have been fleeing emerging economies for the safety of the U.S. dollar. Weak Asian economies have been hemorrhaging capital at an annualized rate of $75 billion so far this year. Now even more money will flow into U.S. assets as a safe haven, boosting liquidity and the dollar.

Third, the crisis means that emerging-market currencies will get cheaper and their exports more competitive. All Asian currencies will follow the yen downward; either Japanese Prime Minister Junichiro Koizumi's reforms will deepen deflation or disappointment in the lack of reform will sap confidence in Japan. A weaker yen is a sure bet under either outcome. And there is nothing so glorious about the state of reform or trade in other Asian economies to support stronger currencies against the competing yen.

The Latin American crisis is all about weaker regional currencies, too. Foreign investors are unwilling to fund Latin America's external debts, deficits and unsustainable budget arithmetic. The Brazilian real is telling us where the Argentine peso is destined to go: straight down.

Nevertheless, devaluation gains to developing countries are not a net loss for the world's rich economies. Much of the advantage accrues to multinational corporations in the U.S., as well as in Japan and Europe (but to a lesser extent). Emerging markets are the manufacturing end of the U.S. economy and increasingly of Japan's and Europe's too. A U.S. producer of widgets in Asia that sees profits from exports rise because of devaluation is creating wealth for shareholders wherever they are, and for the U.S. economy as well as the Asian one where his plant is located. A higher share price may compound the economic benefits.

Fourth, interest rates in the U.S. will move lower to help the emerging markets and avert a global crisis of confidence. Lower interest rates will also be justified because cheaper imports from emerging markets will help lower U.S. inflation.

Finally the hit to global demand from lower growth in developing economies is too small to matter much. Sure, Japan, Europe and the U.S. have exports to those areas, which account for 19% of the EU's total exports, 41% for the U.S. (27% if Mexico is excluded) to 45% for Japan. This looks high. And undoubtedly Japan is much more vulnerable than the U.S. or Europe. But the economic impact for all three countries is lessened by two factors.

The contribution in terms of value added of emerging-market exports to gross domestic product in the U.S., EU and Japan is only between 2.5% and 3.3% of GDP. That's because exports are a low proportion of GDP in the major Organization for Economic Co-operation and Development countries. And many of these exports are ultimately re-exported to rich countries as finished products from emerging economies. In other words, the sale of an Intel chip to Taiwan may be re-exported as part of an IBM ThinkPad to the U.S. or Europe. Such exports are unaffected by a downturn in domestic demand in emerging markets.

And it is precisely to domestic demand in crisis countries that the hit will come. It will make access to foreign capital even more difficult, and certainly more expensive, for all the emerging markets. Access to foreign capital will be impossible for quite a few economies. To find out which, let us first anatomize the causes of this crisis and differentiate it from the global crisis sparked by devaluation of the Thai baht in 1997.

The 1997 crisis was caused by excessive amounts of under-priced debt and equity capital invested at lousy rates of return in developing economies. Much of this capital was debt. In general, capital was advanced on the assumption that Asian fixed-exchange rates would remain fixed forever -- despite being unmatched by the economic liberalization needed to sustain them. No devaluation risk was priced into U.S. dollar loans. It was cheaper to borrow dollars in Thailand than baht, whether the borrower had dollar assets or revenues or not -- and most debtors didn't. When the baht exchange rate cracked the stock of outstanding capital and new flows were re-priced to reflect those "new" risks. Most of the loans became instantly insolvent. Collapsing asset prices and investment then deflated the economies.

The common denominator of today's crisis is reliance on high cost foreign capital to fund unsustainable external and fiscal deficits. Ironically, the locus of the crisis in Argentina and Turkey underscores the fact that the issue is not overinvestment, as in 1997. These economies are, if anything, investment starved! Before 1997, no Asian economy showed the death symptoms of excess government deficits and debts, high interest rates, stagnation and capital flight. That was a Latin disease. Now it's Thai, Malaysian and Indonesian.

These death characteristics are normally government's fault. Government dissaving means that there is an inadequate primary surplus to stabilize public debt to GDP. And public-sector borrowing crowds out productive investment. That kills growth. Put in another way: An economy with these characteristics is caught in an incipient public-sector debt trap. That's because the cost of debt is higher than the rate of growth. Then the budget deficit will automatically keep public-sector debt growing faster than GDP.

A contingent weakness is a currency peg that results in an unsustainably high (real) exchange rate. That's a structural weakness common to Argentina and Malaysia. The fault is not inherent in the currency peg system itself. It stems from a failure to liberalize domestic markets for labor, assets and output sufficiently to support the peg system.

Think of it like this: A currency peg rules out currency adjustment -- call it external devaluation or revaluation -- as a tool for maintaining competitiveness. Instead, it is domestic costs and prices that must adjust an internal devaluation or revaluation. Unless this internal adjustment happens, a pegged currency can appreciate in real terms -- either because the inflation in the pegged currency is higher than that of trading partner currencies, or, as in Argentina's case, because major trading partners devalue their currencies without incurring a big inflation penalty, like Brazil did. That forces even greater pain on the pegged economy. Its costs, and asset prices have to fall even more.

The failure of pegged systems usually lies in a linkage of systemic flaws: a lack of confidence in the peg that keeps interest rates high. That causes inadequate investment and often an unsustainable fiscal deficit. The result is low growth and poor return on assets. Then capital flees in search of higher returns. Consequently, monetary deflation sets in. But at the root of all these failures is one common denominator: a lack of investor confidence in the political process to make the peg work by letting markets set domestic asset prices, incomes and costs. That is Argentina's dilemma today and it will be Malaysia's tomorrow.

Contagion will take out emerging markets that share these death characteristics. Those that share some or all of them are Argentina, Brazil, Turkey, Malaysia, Thailand and Indonesia. The markets that don't have these characteristics, but have suffered a big sell-off in recent days, are South Africa, Mexico and Russia.